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risk and return relatinship

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Hiranya Dissanayake

Lecture Outline

• How to measure Return

• How to measure Risk

• Risk Return Tradeoff

• Group Work

RETURN

What is Return?

• “Income received on an investment plus

any change in market price, usually

expressed as a percent of the beginning

market price of the investment “

What are the components of Return?

Components of Return

Components of Return

Yield

• The most common form of return for investors is

the periodic cash flows (income) on the

investment, either interest from bonds or

dividends from stocks.

Capital Gain

• The appreciation (or depreciation) in

the price of the asset, commonly

called the Capital Gain (Loss).

Example

• Amal purchased a stock for Rs. 6,000. At the end

of the year the stock is worth Rs. 7,500. Ali was

paid dividends of Rs. 260. Calculate the total return

received by Amal.

Expected Return

The investor cannot be sure of the amount of return

he/she is going to receive.

Expected return is the weighted average of

possible returns, with the weights being the

probabilities of occurrence

Formula

• E ( R ) = X* P(X)

return, P(X) shows the probability of various return

Introduction

• Risk cannot be avoided.

• Everyday decisions involve financial and economic

risk.

– How much car insurance should I buy?

– Should I refinance my mortgage now or later?

• We must have the capacity to measure risk to

calculate a fair price for transferring risk.

5-23

Defining Risk

• According to the dictionary, risk is “the possibility

of loss or injury.”

• For outcomes of financial and economic decisions,

we need a different definition.

payoff to an investment, measured over some time

horizon and relative to a benchmark.

5-24

Defining Risk

1. Risk is a measure that can be quantified.

– The riskier the investment, the less

desirable and the lower the price.

2. Risk arises from uncertainty about the future.

– We do not know which of many possible

outcomes will follow in the future.

3. Risk has to do with the future payoff of an

investment.

– We must imagine all the possible payoffs

and the likelihood of each.

5-25

Defining Risk

4. Definition of risk refers to an investment or

group of investments.

– Investment described very broadly.

5. Risk must be measured over some time

horizon.

– In general, risk over shorter periods is

lower.

6. Risk must be measured relative to some

benchmark - not in isolation.

– A good benchmark is the performance of a

group of experienced investment advisors

or money managers.

5-26

Measuring Risk

• We must become familiar with the mathematical

concepts useful in thinking about random events.

• In determining expected inflation or expected

return, we need to understand expected value.

– The investments return out of all possible

values.

5-27

Possibilities, Probabilities, and Expected

Value

• Probability theory states that considering

uncertainty requires:

– Listing all the possible outcomes.

– Figuring out the chance of each one occurring.

• Probability is a measure of the likelihood that an

event will occur.

• It is always between zero and one.

• Can also be stated as frequencies.

5-28

Possibilities, Probabilities, and Expected

Value

• We can construct a table of all outcomes and

probabilities for an event, like tossing a fair coin.

5-29

Possibilities, Probabilities, and Expected

Value

• If constructed correctly, the values in the

probabilities column will sum to one.

• Assume instead we have an investment that

can rise or fall in value.

– $1000 stock which can rise to $1400 or fall

to $700.

– The amount you could get back is the

investment’s payoff.

– We can construct a similar table and

determine the investment’s expected value

- the average or most likely outcome.

5-30

Possibilities, Probabilities, and Expected

Value

multiplied by their payoffs.

5-31

• Are you saving enough for retirement?

• You might be tempted to assume your investments

will grow at a certain rate, but understand that is

not the only possibility.

• You need to know what the possibilities are and

how likely each one is.

– Then you can assess whether your retirement

savings plan is risky or not.

5-32

Possibilities, Probabilities, and Expected

Value

What if $1000 Investment could

1. Rise in value to $2000, with probability of 0.1

2. Rise in value to $1400, with probability of 0.4

3. Fall in value to $700, with probability of 0.4

4. Fall in value to $100, with probability of 0.1

5-33

Possibilities, Probabilities, and Expected

Value

Expected Value =

0.1x($100) + 0.4x($700) + 0.4x($1400) +0.1x($2000) = $1050

5-34

Possibilities, Probabilities, and Expected

Value

• Using percentages allows comparison of returns

regardless of the size of initial investment.

– The expected return in both cases is $50 on a

$1000 investment, or 5 percent.

• Are the two investments the same?

– No - the second investment has a wider range of

payoffs.

• Variability equals risk.

5-35

Measures of Risk

• It seems intuitive that the wider the range of

outcomes, the greater the risk.

• A risk free asset is an investment whose future

value is knows with certainty and whose return is

the risk free rate of return.

– The payoff you receive is guaranteed and cannot

vary.

• Measuring the spread allows us to measure the

risk.

5-36

Variance and Standard Deviation

• The variance is the average of the squared

deviations of the possible outcomes from their

expected value, weighted by their probabilities.

1. Compute expected value.

2. Subtract expected value from each of the

possible payoffs and square the result.

3. Multiply each result times the probability.

4. Add up the results.

5-37

Variance and Standard Deviation

1. Compute the expected value:

($1400 x ½) + ($700 x ½) = $1050.

2. Subtract this from each of the possible payoffs and square the results:

$1400 – $1050 = ($350)2 = 122,500(dollars)2 and

$700 – $1050 = (–$350)2 =122,500(dollars)2

3. Multiply each result times its probability and add up the results:

½ [122,500(dollars)2] + ½ [122,500(dollars)2] =122,500(dollars)2

The Standard deviation is the square root of the variance:

= = 2 = $350

Variance 122,500dollars

5-38

Variance and Standard Deviation

• The standard deviation is more useful because

it deals in normal units, not squared units (like

dollars-squared).

• We can calculate standard deviation into a

percentage of the initial investment, $1000, or

35 percent.

• We can compare other investments to this

one.

• Given a choice between two investments with

equal expected payoffs, most will choose the

one with the lower standard deviation.

5-39

Measuring Risk: Case 2

5-40

Variance and Standard Deviation

• The greater the standard deviation, the higher the

risk.

– Case one has a standard deviation of $350

– Case two has a standard deviation of $528

• Case one has lower risk.

• We can also see this graphically:

5-41

Variance and Standard Deviation

5-42

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